After the crisis of 2008, global finance, starting in the United States, plainly needed better regulation and supervision. Lots of institutions had turned out to enjoy taxpayer backing because they were perceived to be too big to fail. Huge derivatives exposures had gone unnoticed. Supervisory responsibilities were too fragmented. The Dodd-Frank act came into life in July 2010, and attempted to address these issues under four axes: securitisation, compensation, liquidation and systemic risk (too big to fail). Two years now since Dodd-Frank, how has the situation evolved?
Several analysts, using data from the FFIEC, recently picked up on the very verifiable story that America’s big 5 have in fact gotten even bigger compared to pre-crisis levels. see here and here. I reworked the numbers using the same source data and came up with a slightly nuanced outcome: big banks are indeed as big or even bigger than what they were prior to Dodd-Frank (depending on what your base comparison year is), but the ratio of the top 5 bank holding companies to real US GDP (most other analysts use nominal GDP) has been steadily decreasing since 2009. It currently stands at 65% of real US GDP, or $8.7 trillions (see below), compared to 68% at end-2009. So, to be fair, if we’re trying to answer the question of whether Dodd-Frank brought about positive changes to the “too big to fail” dilemma, the comparison should be between today and 2010, not 2007.
This said, I personally think that the emphasis should be placed more on the soundness and stability of a bank rather than its relative size, the simple argument being that if a bank is well capitalized, liquid, and overall sound in its credit positions, then the “fail” part of “too big to fail” would be taken care of, and the “too big” part would become irrelevant. Krugman and I seem to be in agreement, and he further adds that “the pursuit of a world in which everyone is small enough to fail is the pursuit of a golden age that never was.” Regulate and supervise, and do it right and airtight.
Speaking of banking stability and soundness, are big banks today any more solvent (and, by direct consequence, less leveraged) than they were pre-crisis? Hardly, judging by the latest data, again from the FFIEC. See for yourself below. Granted, the Tier 1 leverage ratio is hardly a comprehensive assessment of bank stability and soundness (I should know, I’ve been drafting banking sector stability reports for the IMF for 10 years), but it is a fundamental measure of solvency, hence potential bankruptcy and failure. This is what the Fed’s stress testings are all about: will the banks have enough capital to sustain operations and pay back shareholders and creditors in severely adverse scenarios? The news was conveyed last month in the resultsof the Federal Reserve’s latest bank stress tests. As presented by the Fed, most of the news was good. Some large financial institutions were judged likely to have sufficient equity capital even if the U.S. economy were to experience a significant downturn. With that, banks such as JPMorgan were allowed to increase their dividends and even buy back shares. But there’s a problem, and it’s not a small one. If you buy the Fed’s view of what is likely to constitute stress, there is some justification for its action. But why would we let banks reduce their capital in the face of so much financial and economic uncertainty around the world (re: Europe)? We all know that lower equity at big banks means higher expected losses for taxpayers down the road: The disaster of 2008 caused about a 50 percent increase in U.S. debt relative to gross domestic product — the second largest shock to the country’s balance sheet after World War II.
On these stress tests, the Fed’s assumption in the stress scenario that Europe would have a mild recession seems too benign given the latest developments re: Spain, Portugal, Greece. How much faith do we have in these stress tests? a combined 96 percent of North American financial services professionals were “not at all confident” or only “somewhat confident” that the Fed’s stress testing addresses all of the important risks to the banking system, according to a recent Sybase survey.
So we’ve established that big banks are as big or even bigger than they were pre-Dodd-Frank, and possibly as thinly capitalized and over-leveraged as ever, but are they more prosperous? you bet, not quite as rich as 2007, but getting there quickly and steadily. See below.
The financial system it seems hasn’t become safer since September 2008. We are not in a strong position to weather any financial storm that starts gathering on the horizon, and that should be ample cause for concern.